WFC: Expect Modest Negative Revisions to Revenue and EPS
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December 17, 2015
WFC: Expect Modest Negative Revisions to Revenue and EPS
“We offer our customers the most extensive, convenient distribution system in our industry which enables us to serve our customers in more locations than any other bank … more than 75% of our deposit customers visit a banking store at least once every six months … I think a significant part of the value of the franchise is $1.2tn of deposits at 8 basis points” WFC CEO John Stumpf, Dec 2015
- Consensus calls for 6% revenue growth at WFC in 2017 are too high, and we expect negative earnings revisions even assuming the bank lowers the efficiency ratio towards 55% (the low-end of the guidance range of 55-59%) from the 2015 level of 58%.
- The effect cannot be offset through capital management because, as OCI losses increase (to our estimates of $2bn in 2016 and $1bn in 2017 versus $1.6bn in 2015), the net payout ratio will be constrained towards the low-end of management’s guidance range of 55-75% particularly in 2016; indeed, we expect the average stock count in 2017 to be 2-3% higher than implied by consensus.
- At 2x tangible book, WFC is fairly valued given a tangible ROE of 16-17% and, with no near-run improvement in profitability, we expect the stock price to increase at the same rate as the 6-7% annual increase in tangible book for a total return, including the ~3% dividend yield, of 9-10%.
- While WFC is strongly positioned for the long-run, with particular opportunity to build its card and wealth management franchises, we prefer BAC in the near-run for its capital and operating leverage. Comparative advantage from WFC’s lower-beta deposit franchise will likely not manifest until after the 100bps of rate tightening since, initially, consumers are unlikely respond so that banks will benefit relatively evenly from rising deposit spreads.
Chart: Valuation Regression for US Banks (SIFIs indicated by red dots)
Consensus revenue forecasts for WFC appear optimistic and will likely come in several hundred million dollars in 2016 and closer to a billion in 2017; combined with the impact of OCI losses as rates back-up, and consequent constraining of the net payout ratio to the low-end of management’s guidance range of 55-75%, this will cause earnings estimates to come in below consensus. Specifically, we model $4.33 in 2016 and $4.58 in 2017 representing about a dime and two dimes below consensus respectively. At 2x tangible book, the stock as fairly valued given a tangible ROE of 16% and, with no near-run improvement in profitability, we expect the stock price to increase at the same rate as the 6-7% annual increase in tangible book for a total return, including the ~3% dividend yield, of 9-10%. The energy portfolio, representing ~2% of WFC’s $900bn loan book is a potential wild card and we expect this to contribute to a net small (<$100mm) reserve build in the fourth quarter versus the releases of the first half.
Few banks have been more insistent than WFC on the importance to its deposit franchise of the branch-network. Management believes its distribution network provides comparative advantage which will become increasingly evident as rates back-up – not for the first 100bps when WFC agrees with JPM (Chart 1) that consumers will not respond meaningfully to the price-signal so that all banks benefit roughly equally from rising rates, but thereafter when consumers do start to respond (by shifting deposit accounts between providers for higher rates) so that banks with stickier balances are comparatively advantaged through lower repricing “betas”. As CEO John Stumpf observes “the more core, the more checking account, the smaller the balance and the more retail, the less the response rate will be [versus] the more [large] corporate”.
Chart 1: JPM Deposit Rates Paid in Rate Cycle from Dec 2003 – Dec 2006
Source: JPM Investor Presentation June 2014
This comparative advantage could be substantial: in the last up-rate cycle, from 2004Q2-2006Q3, the top-performing quartile of banks had a repricing beta of 33%, so raised deposit rates by 33bps for every 100bps increase in the Fed Funds rate, while the equivalent figure for the worst-performing quartile of banks was 78%. The median was 52% and almost everyone focused on the demand-side believes the figure will be higher this time around given that online banking has lowered account switching-costs and increased consumer awareness of rate differentials; however, there are important supply-side dynamics in that banks have excess liquidity and deposits, so loan-to-deposit ratios are well under 100% and Fed balances are enormous, and there few yield opportunities now and likely in the early stages of rate-tightening. For example, WFC has $1.2tn of deposits, $900bn of loans, and $200-300bn of Fed balances.
Our own empirical analysis, published in mid-2013, suggests that WFC is correct that it has some of the stickiest and lowest-cost deposits in the industry largely because growth in consumer deposits is driven by transactional (i.e. checking) accounts across individuals and small-businesses. However, CEO Stumpf acknowledges that “none of us know” how deposit-customers will behave. In practice, we believe analysts are optimistic in calling for WFC to near 6% revenue growth in 2017 (versus 2.5% in 2015); if we assume non-interest revenue can grow at 3% (versus 1% in 2015), this means the GAAP net interest margin needs to increase by 25bps over two years to 3.15% in 2017 from an expected 2.90% in 2015.
It is a tall order when the firm may need to issue ~$25bn of long-term debt to comply with TLAC requirements and when, as CEO Stumpf comments (topically in light of spread-widening in high-yield for example and given real-estate cap rates in the 4’s), “there is still a lack of earning assets of almost any asset class that is properly priced for risk”. He adds that the biggest opportunity for net interest income is to employ more assets, but it is also the biggest challenge; the GE deals this year, including $12bn in commercial real estate loans in the second quarter and announcement of $32bn of loans from GE’s commercial distribution and vendor finance businesses in the third quarter help both in the near-run (through improving the balance-sheet returns) in the longer-run (through the origination platform and customer-facing systems).
Nonetheless, we expect below-consensus increases in the net interest margin, albeit enough to generate 7% growth in net interest income, so that WFC revenue-estimates come in. Even assuming modestly normalizing credit performance and that WFC operates at the 55% lower-bound of its efficiency ratio, this means that EPS estimates must also come by nearly a dime in 2016 (on a base of $4.40) and nearly two in 2017 (Chart 2). Key assumptions in our model, beyond those for the efficiency ratio, are that non-interest revenue will not grow faster than 3% and that the net payout ratio will be near the low-end of management’s guidance range of 55-75% particularly in 2016 and that, as a result, share-count reductions will be less than consensus. We discuss these assumptions below.
Chart 2: WFC EPS Drivers
Source: Company Reports, SSR Analysis
Non-Interest Income at WFC
The secular narrative for non-interest revenue growth at WFC is compelling. Managing $1.9tn of assets, the firm has at most a 2% penetration of the wealth management business (compared with 11% penetration of transactional accounts) and can gain share simply by attracting the substantial away-balances of its customers particularly among the “get-rich” emerging affluent (through its 15,000 financial advisors) and the “stay-rich” wealthy families through Abbot Downing. In addition, only 43% of WFC’s banking customers carry a WFC credit card and, even though this penetration is up from 20% at the time of the financial crisis, it means over half of WFC customers do not carry a WFC credit card. Given its distribution network (and increasing focus, through the American Express partnership for example, on affluent households as well as first-time cardholders such as students), WFC claims it can acquire new card accounts at about “a third the cost” of others (so ~$55/account given average acquiring costs for prime accounts are ~$165/account) through emphasizing branch-distribution over “cold” direct-mail and internet advertising.
The challenge is that, ex-card fees growing at ~10% annually and representing near 10% of the total, non-interest income is flat. This is because the mid-single digit growth in trust and investment fees, representing near 40% of the ex-card total, is offset by flat growth in deposit service charges, negative growth in mortgage banking income, and volatility in the other income streams (including, apart from insurance and leasing, gains on sale of debt and equity securities and accounting, in total, for over 25% of non-interest revenue – Chart 3). While growth in mortgage-banking revenue was affected by tough compares in 2013, we do not expect growth in overall non-interest income to exceed 3% given that deposit fees are likely to be flat to down (given regulatory pressures) and as trust and investment fees trend around normal growth of 4-5%.
Chart 3: WFC – Non-Interest Revenue
Source: Company Reports, SSR Analysis
WFC faces a minimum target, including the Fed surcharge, of 9% for the ratio of common-equity-tier-1 (CET1) capital to risk-weighted assets (RWA). This is low relative to bank competitors (11.5% at JPM, 10.5% at C, and 9.5% at BAC, GS, and MS), but the firm is running a meaningful buffer with a present CET1 ratio of 10.7% and displays no urgent inclination to reduce it. Commenting on the excess capital in November, CFO John Shrewsberry noted that “we know that in the case of CET1, the consequences [of missing the minimum regulatory target] are you cut off your dividend and don’t pay people which seem like strong consequences and probably worthy of carrying a buffer”. He adds that some analyst assumptions for reducing the buffer are “unrealistic” and our model therefore maintains it at current levels.
After making some additional assumptions for OCI losses on the available-for-sale securities portfolio (specifically a loss of $2bn in 2016 and half that in 2017), the net payout ratio cannot rise beyond 65%, which is the mid-point of management’s guidance range for 55-75%, and in 2016 will be at the low end. The OCI constraint on the net payout ratio does not appear to be reflected in consensus with the result that our model shows less buyback than implied by analyst estimates. Specifically, given our assumptions that the ROA stays roughly flat at just under 1.4% and the tangible ROE at just over 16%, WFC can buyback of ~$4bn in 2016 (flat to 2015) rising to ~$5.5bn in 2016 and 2017. The result is that our estimate of the average diluted share count in 2017 is 3% higher than implied by consensus contributing to an EPS estimate of $4.58 versus consensus of $4.77.
The key risks to our cautious near-run thesis on WFC is that the revenue-margin expands faster than we model, either because of a more favorable rate-environment or positive surprise on non-interest revenue, or the firm is able to draw down capital, and hence buyback stock, more than we model. In the first case, we prefer BAC in the early stages of an up-rate cycle because it is simply more levered to improving deposit spreads and, as noted, the possible comparative advantage of WFC will not kick-in until after the first 100bps of tightening. In the second case where, as OCI losses are realized WFC draws down the CET1 ratio from the current 10.7% towards say 10.5%, the net payout ratio increases to 65-70% but there remains a shortfall in terms of stock reduction relative to current consensus.
©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein. The views and other information provided are subject to change without notice. This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. The analyst principally responsible for the preparation of this research or a member of the analyst’s household holds a long equity position in the following stocks: JPM, BAC, WFC, and GS.
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